THE IMPACT OF THE CAPITAL MARKET
CHAPTER 8 CREDIT RATIONING
8.7 THE EXISTENCE OF CREDIT RATIONING
An important contribution to the controversy is made by Hansen and Thatcher (1983) who question the very existence of credit rationing, as exempli¢ed by the Stiglitz^Weiss approach. Their approach distinguishes between the e¡ect on the loan size of the promised loan contract rate and the loan contract quality or risk class.
The rate charged on the loan (i.e., the loan contract price) depends on the risk quality of the particular loan (or loan class) and shocks to the risk-free rate of interest.
The risk quality of the loan is measured by the size of the loan (L) divided by the amount of collateral o¡ered (C). The risk quality of a loan will decrease as eitherL decreases orCincreases. The loan contract price increases with either increases in risk quality or the risk-free rate of interest. The loan contract price is given by r¼rð; Þ, where¼L=C. The riskless rate of interest isr¼rð0; Þ.
The analysis can be presented diagrammatically in Figure 8.6 with the size of loan demanded on the horizontal axis and the risk-free rate on the vertical axis. The demand curve for loans given the quantity of risk category slopes downwards because as the risk-free rate falls the loan price will also fall, causing an increased demand for loans.
The initial demand curveD0 is drawn for a given and constant risk category (0) and the equilibrium is shown atL0. The e¡ect of a rise in the risk-free rate for the same quality of loan is shown byrð0; 1Þand the loan size demanded is now L1. The rise in the interest rate and its e¡ect on loan demand can be decomposed into two e¡ects: a ‘pure demand e¡ect’ and a ‘loan quality e¡ect’. The pure demand e¡ect is shown by a movement along the demand curve from L0;rð0; 0Þ to L1;rð0; 1Þ. However, the rise in the loan rate may cause the borrower to alter the quality of the loan by varying the quantity of collateral. Suppose, for example, the rise in the riskless rate causes the borrower to raise the quality of the loan. This is shown in Figure 8.6 by the shift inwards of the demand curve to D1. The new
equilibrium for loans becomesL01. The improvement in the loan quality opted for by the borrower augments the pure demand e¡ect and leads to a lower loan size, giving the impression of being rationed. But this is a self-rationing outcome. The borrower elects a smaller loan size at a lower loan rate. Thus, the ¢nding that banks are unwilling to lend an unlimited amount of funds at a particular rate of interest is not an argument that supports the existence of credit rationing. The analysis is presented more formally in Box 8.4.
The notion that the loan-pricing function is more complicated than the loan interest rate raises all sorts of issues concerning the noninterest elements of the price.
It can be argued that the loan-pricing function includes conditions of the loan that vary with the loan size. The promised loan contract rate is the standard loan rate for what appears to be a standard debt contract. For a larger loan size the contract includes other conditions such as collateral, periodic monitoring, maturity, fee, reporting and, in the extreme case, a representative of the bank on the board of directors. These may be conditions that the borrower is unwilling to meet and, therefore, opts for a lower loan size. The result is that the borrower has gone to the bank with a desired loan as shown in Figure 8.7 ofL0at a perceived loan price of r0¼ ðrð0Þ;Xð0ÞÞ, where X describes the conditions of the loan andXð0Þmeans that there are no conditions except for loan repayment at the speci¢ed rate. After realizing the true price of the loan the borrower chooses a lower loan size, shown as L1, at the loan price which includes condition XðzÞ. This is a self-rationing outcome and could not be viewed as the same type 1 class of credit rationing examined in the literature.
It is clear that the debate on the issue of credit rationing has barely left the theoretical level. The theoretical existence or nonexistence of credit rationing does not seem to have in£uenced the attitudes of policy makers and commissions of
THE EXISTENCE OF CREDIT RATIONING 125
FIGURE 8.6
Hansen and Thatcher model r(φ,θ)
L r(φ0,θ0)
L0
L1
r(φ1,θ1) r(φ0,θ1)
D Dφ0
Dφ1
L’1
enquiry. The Wilson Committee (1979) took the view that the conditions of the loans for Small- and Medium-sized Enterprises (SMEs) were severe and created de facto rationing. The Cruikshank Review (2000) examined the overdependence of SMEs on the banks because of the inadequacy of capital market ¢nance. Goodhart (1989), at the time a senior economic adviser at the Bank of England, stated that although economic theory can devise e⁄cient contracts that may eliminate credit rationing in theory, ‘in practice it exists’. This assertion is reminiscent of the old joke that an economist sees something working in practice and asks: Does it work in theory?
BOX 8.4
Hansen and Thatcher
The loan contract price is given byr ¼rð; Þ, where¼L=C (a measure of the risk class) andCis collateral or own equity, andrepresents shocks to the riskless rate. The promised loan rate is a convex function of the loan risk class, so:
r¼@r
@>0; r>@2r
@2>0
The riskless rate of interest isrð0; Þand for any particular riskless rate there is a loan-rate-pricing function that is convex in risk class. The loan-contract- pricing function also has the property that:
r¼@r
@>0
The loan-contract-pricing function has the condition that increasing risk pre- miums are required for increasingly riskier loan contracts. Also, the level of the interest rate is higher for higher levels of the riskless rate. Shocks to the riskless rate affect both the loan contract size and the loan contract quality. The total effect of an increase in the riskless rate of interest on the loan size is decom- posed into two effects: a ‘pure demand effect’ and a ‘loan quality effect’:
dL d¼@L
@
d¼0@L
@
d¼0
d d
The second part of the right-hand side of this expression is the product of the effect on the loan size of a change in the loan quality risk class at the initial riskless rate and the effect on the loan quality due to a change in the riskless rate. The higher riskless rate of interest may cause the loan quality to worsen or improve based on the ratio of loan to collateral offered by the borrower.
Basically, the sign ofd=dis ambiguous. Suppose the rise in the riskless rate causes the borrower to raise the quality of the loan, the borrower will demand a lower loan size than that given by the pure demand effect of a rise in the loan rate.